The final report by Sir David Walker on the result of his review of corporate governance in UK Banks and other financial industry entities was released in late 2009 and can be accessed on the website of HM Treasury UK.
This update follows our October comments on the draft issued in July 2009 and, while the recommendations in the report as to director and executive remuneration and incentive payments is of relevance in light of the recent report by the Australian Productivity Commission regarding the same issue, other recommendations contained in the report are connected to current questions as to corporate governance and the function, duties and effectiveness of Corporate Boards in Australia. As presently advised, the recommendations contained in the report have been accepted by the Treasury and will be implemented by regulation and legislation over the next 12 months.
The context of the Report is expressed best in Sir David’s own words,
“The massive dislocation and costs borne by society justify tough regulatory action as is now being put in place to minimise the risk that any such crisis could recur. The context is a major asymmetry under which, from one standpoint, the liability of shareholders in major listed banks is limited to their equity stakes, while from the other standpoint, at any rate on the basis of recent public policy initiative and experience in the UK, the United States and elsewhere, the liability of the taxpayer is seen to have been unlimited.- (Page 6)”.
However, the report is very much aware of the need to strike a balance between the constraints of financial regulation, and the ability of Bank Boards to be inventive and risk taking in the interests of their shareholders, he notes “an important concentricity between public policy objectives and the interests of shareholders” (Page 24). Recognising the essential contribution of the Banks to the wider economic recovery, he feels that undue regulation might well hamper that contribution bringing with it material costs and that enforced disintermediation (if the Treasury were to implement a policy of breaking up the major banks) could deprive the general public of many services now made available to them by those banks.
“Thus the public authorities in the widest sense have a broad interest in the overall financial health and performance of financial institutions in society as a whole. - (Page 24).
This balanced and reasonable approach is in contrast to the U.S. proposals to require major banks to divest their hedging funds management and derivative operations and to cease all proprietary trading and also to the China/India solution (floated by the FSA at Davos) of imposing an external independent Credit/Risk monitor. While recognising the limited liability of equity holders, the report also appreciates their vulnerability in noting the frightening loss of value of shareholdings during the GFC:
“Ideally, corporate governance and regulation of a financial entity should be mutually reinforcing. They were palpably less than adequately so in important recent experience, as UK taxpayers face huge underwriting and other costs and many shareholders in UK BOFIs saw more than 60% of the market value destroyed.” - (Page 25.)
It is beyond the scope of this article to exhaustively examine and discuss the 37 final recommendations of the Report, but it is hoped that this short abstract provides a general overview of the regime proposed by Sir David Walker (and shortly to be implemented) and may provoke debate as to the appropriateness of these recommendations in the Australian environment.
Board Size Composition and Qualification (Recommendations 1 to 5 incl)
NEDs should be provided with substantive induction training and development to ensure thematic business awareness which will enable them to contribute effectively to the Board. There should be dedicated support for them in matters relevant to the business, which may require advice separately to that available in the normal board process.
Letters of Appointment of NEDs to BOFIs should clearly express a minimum time commitment to the board which should be in the vicinity of 30 to 36 days per year and if a lesser commitment is approved, it should be clearly expressed in the Letter of Appointment together with a justification for that arrangement. Letters of Appointment should be available to shareholders on request.
The FSA should supervise the composition, balance and effectiveness of the BOFI Boards having regard to the risk strategy of the business and taking account of individual directors’ experience and access to adequate induction and development processes. The FSA interview process for NEDs proposed for BOFI boards should involve discussions with, and assessment by, a senior independent advisor with relevant industry experience.
Functioning of the Board and Evaluation of Performance (Recommendations 6 to 13 incl)
NEDs of BOFI Boards should be encouraged to challenge and test proposals put forward by executives and satisfy themselves that the strategy is based on comprehensive internal and external information, analysis and input. The chairman of a major bank should be expected to commit around two thirds of his time to the business of the entity on the understanding that his chairmanship would take priority over any other business time commitment.
Lesser time commitments could be considered appropriate for smaller or less complex banking entities. The chairman should provide leadership to the Board above all else and should have an ongoing induction and business awareness programme to ensure that he or she is abreast of new developments in the business. He is responsible for ensuring the effectiveness of the board and for setting its agenda to ensure substantive discussion on strategic issues. He should promote the informed and critical contribution of his board particularly on matters of risk and strategy, promote effective communication between its members and ensure that all relevant information is distributed to all directors in timely fashion and accurate form. He should be proposed for election on an annual basis and boards should keep under review the possibility of transitioning to annual election of all board members.
A SID should be recognised to work closely with the chairman, to represent the NEDs in discussions with the chairman and to be available to shareholders when the chairman is not. The board as a whole should undertake formal and rigorous evaluation of its own performance and that of its committees with external facilitation every second or third year. A statement of this evaluation should be contained in the chairman’s statements or as a separate section of the annual report, together with identification of any external facilitator and a clear indication of his independence. The statement should describe the process, set out the results and address the extent to which recommendations have been implemented. Shareholders’ views on the performance of the Board should be published with an indication of any action undertaken by the Board as a result thereof.
The Role of Institutional Shareholders, Communication and Engagement (Recommendations 14 to 22 incl)
(These recommendations may not be as relevant to Australian circumstances as the others, given that Australian institutional shareholders are rarely noted for being overly passive. However, these recommendations do provide an interesting context to those more specifically relating to the province and conduct of the Board.) The Board should ensure that it is made aware of any material cumulative change in the share register at the earliest possible time and, should it occur over a short period, advise the FSA immediately.
[Recommendation 15 in the Draft that the FSA should then quiz the institutional shareholder and where appropriate meet with the Board to determine what the Board intended to do as a result of the change on its register has been deleted in the final report].
The FRC is to develop a new “Stewardship Code” separate from the Corporate Governance Provisions of the Combined Code and in doing so should ratify the Code on the responsibilities of institutional investors introduced by the Institutional Shareholders Committee. It will then be monitored by the FRC on a “comply or explain” basis. It should be reviewed on a regular basis by the FRC in consultation with interested parties and adapted to circumstances as appropriate. Institutions approved by the FSA to undertake investment business will be required to signify on their websites whether or not they commit to the Stewardship Code together with an indication of their engagement policies in the discharge of their obligations under the Code.
There should be regular surveys of institutions which have committed to the Code to monitor adherence and institutions electing not to commit to the Code should be required to explain their alternative business model and the reason for the position it is taking. Institutional investors are to be encouraged to seek opportunities for engagement with their investee companies to promote sustainable improvement in performance and should be active in inviting foreign institutional investors to commit to the Stewardship Code.
They should always exercise their voting powers and should disclose their voting record and policies in respect of voting on their websites or in another publicly accessible form.
Governance of Risk (Recommendations 23 to 27 incl)
BOFIs should establish a Board Risk Committee separately from the Audit Committee. This Committee will advise the Board on current risk exposure and future risk strategy and ensure the management of risk alongside established rules and procedures. It should do so having regard to current financial environment and external assessment from authoritative sources, (e.g. Bank of England, FSA).
The Board should be served by a CRO who should assist the Committee at the highest levels in risk management and oversight independently from individual business units. CRO should have a direct reporting line to the chairman of the Risk Committee and his removal or replacement only to be effected by prior agreement of the Board. The Risk Committee should consider added value from external input (in the Draft this was an absolute requirement) and in the event of proposed acquisition or disposal, it should be prominent in determining the element of risk after proper due diligence appraisal.
The report of this committee should be included as a separate report within the annual report and accounts with full disclosure of the process of risk management and the result of stress testing of strategy involving risk exposure or appetite, the annual report should disclose the membership of the Committee, the frequency of its meetings and its access and usage of external advice.
Remuneration (Recommendations 28 to 39 incl) (the one we have all been waiting for)
The Board’s Remuneration Committee should be enabled to adopt a coherent approach to all employee remuneration. Its terms of reference should include the establishment of principals and parameters of remuneration policy, particularly with regard to “high end” employees in relation to whom the report of the committee should confirm the board’s satisfaction with the way in which performance hurdles and risk adjustments are reflected in the compensation structure and set out the principles underlying those factors.
For major BOFIs (listed and unlisted) the Remuneration Committee Report for the 2010 year of account and thereafter should set out all “high end” employees including executive board members in expected remuneration bands of £1 million to £2.5 million, £2.5 million to £5 million and above £5 million indicating the main elements (e.g. salary, cash bonus, deferred shares, performance related, long term and short term awards and pension contributions). In so far as possible the report should indicate the areas of business to which these higher bands relate.
This requirement will apply to UK domiciled subsidiaries of non-resident entities from 2010 onwards. Deferral of incentive payments is to provide the primary risk adjustment mechanism to link rewards to sustainable performance. At least one half of variable remuneration is to be in the form of long term incentives with vesting subject to performance, as to half not less than 3 years and the balance after 5 years. Short term bonuses should be paid over a 3 year period by equal instalments and “claw-back” should be used where appropriate.
This structure is to be incorporated in the FSA Remuneration Code Review Process in 2010 and Remuneration Committee Reports for 2010 and thereafter must indicate compliance on a “comply or explain basis”. High end employees (including executive board members) will be expected to maintain a shareholding or retain a portion of vested awards in an amount in line with their total compensation.
The Remuneration Committee should meet with the Risk Committee on specific risk adjustments to be applied to performance objectives with any difference of view being decided by the Chairman and NEDs on the Board. If a non-binding resolution on a Remuneration Committee Report attracts less than 75% of total votes cast, the Chairman of the Committee must stand for re-election in the following year irrespective of his appointment term.
The Report must state whether any high end employee (or executive director) is entitled to receive enhanced benefits on termination, resignation, retirement or change of control and whether any such enhanced benefits have been provided during the reporting year. Apparently, UK Remuneration Consultants have formed a professional group which is preparing a Code to be lodged on the FRC website and all remuneration committees will be required to use that Code as a basis for determining terms of arrangement of external advisory contracts.
A considerable number of submissions were made following the invitation contained in the Draft Report circulated in July 2009. We have made the occasional comment on any new or deleted provision of the recommendations above, but overall it would be fair to say that none of the sharp points in the draft have been blunted, none of its strict requirements have been watered down and, in fact, in the main, amendments appearing in the final report tend to tighten up and extend the application of the original draft recommendation.
